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1 January 1979 Financial Analysts Journal Volume 35, Issue 1

How Lease Capitalization under FASB Statement No. 13 Will Affect Financial Ratios

  1. Monroe Ingberman
  2. Joshua Ronen
  3. George H. Sorter

Lease capitalization under Financial Accounting Standards Board Statement No. 13 can affect key financial indicators. Under capitalization, for example, interest expense, hence total lease expense, decreases over time. While total lease expense under capitalization will initially exceed expense under an operating lease, the difference will eventually reverse.

Since operating expense for the capital lease includes depreciation, but not interest, operating income for the capital lease will often exceed operating income for the operating lease, even though net income for the former is initially less than net income for the latter. Funds from operations under capitalization will exceed funds from operations under an operating lease by an amount equal to the difference between the lease rental payment and interest expense. Since, under capitalization, income increases over time, the difference in funds from operations will also increase over time.

Capitalization decreases working capital by the current portion of the lease obligation, hence reduces the current ratio. Capitalization also increases long-term debt without altering equity, hence increases the debt-equity ratio. Although Statement No. 13 will change financial indicators, however, it will not change economic reality: In every year of a lease, cash flows under capitalization will be identical to cash flows under an operating lease.

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